Real estate darling Teranet troubled by debt

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Monopolies on land registries should make for good business in a real estate boom, yet Teranet was just dealt a debt downgrade.

The company, which controls Ontario and Manitoba's land registry systems, saw its debt downgraded by rating agency Standard & Poor's to 'BBB' from 'BBB+.' The new rating still classifies the debt as investment grade, but it suggests there is more uncertainty about the company's future.

The root reason for S&P's action: too much debt. Or as the rating agency put it, a "highly leveraged financial risk profile over the next few years." You may remember Teranet from its blockbuster $700-million initial public offering in 2006 – a major deal in what was otherwise a slow summer. Just a few months after the IPO closed, management's dreams were dashed when the federal government banned the income trust structure that the company employed. The private equity arm of the Ontario Municipal Employees Retirement System pension fund, which is tax-exempt, ultimately took Teranet private in 2008, and the business looked promising coming out of the financial crisis because the real estate market soared. Teranet makes money by charging fees to buyers and sellers of real estate, who must register land, and it also earns income from those who pay to access the company's database to research properties.

More recently, Teranet has expanded by licensing Manitoba's equivalent land registry, and the company also acquired a New Zealand-based firm that is in the same business. However, those deals came with financial burdens – Teranet paid $75-million up front for Manitoba's business and agreed to help upgrade the province's real estate systems – and commitments such as these have led the company to borrow money.

While debt itself isn't problematic if there are strong revenues to offset the interest payments, S&P worries that Teranet's income streams are looking less lucrative.

The company's "registration activity rate (RAR) has been below our expectations in recent years," the rating agency noted. "The RAR is the company's key revenue driver, and is determined by dividing registration volumes by the total parcel base. We believe a combination of tepid refinancing activity in recent years (given relatively stable interest rates), mortgage rule changes, and structural changes in the composition of the parcel base have contributed to the depressed RAR." Because revenues are weaker, Teranet has less money to cover its interest payments. S&P puts a lot of weight on what it calls the "adjusted funds from operations interest coverage" – and Teranet's adjusted funds from operations amount to only two times its interest payments for the next few years.

By no means is Teranet in dire straits. But the latest downgrade serves as caution, especially if the Ontario and Mantioba real estate markets cool.